Solving the Profit Puzzle

The Origin of Profit in a Circular Flow

The great Richard Cantillon laid the groundwork for Classical Economics with his Essay on the Nature of Trade in General, which introduced virtually every concept that would later be developed by Smith, Ricardo, Say, and their epigones: methodological modeling of economies, the distinction between wealth and money, the subjective theory of value, the derivation of price from supply and demand, the uniformity of profit principle, the quantity theory of money, an advanced theory of interest, the introduction of the concept and term entrepreneurship, and - perhaps most importantly - the first circular flow model of an economy.

In a circular flow model, “the total value of factor inputs must equal the total value of output at nominal prices” (Tomasson & Bezemer, What is the Source of Profit and Interest). However, if this is true, then “the aggregate profit accruing to entrepreneurs must be zero,” and “if all revenues accrue to owners of production factors, no monetary resources should be left for fresh investment leading to economic expansion.” But this is a difficult notion to accept, because the same Classical Economic theories also claim that “economic growth and the pursuit of profit are the motive force of the economy.” The apparent contradiction gives rise to what is often called “the profit puzzle”. What is the source of monetary profit in an economy with a circular flow of money?

The profit puzzle was left unsolved by the Classical Economic school. Karl Marx, in Capital, used the profit puzzle as evidence for exploitation: “How can the entire capitalist class manage to draw continually £600 out of circulation, when it continually throws only £500 into it?” Schumpeter, in his Theory of Economic Development, acknowledged “that the economic system should operate without a profit…is a paradox,” but offered no resolution. Keynes in the General Theory tried to resolve the profit puzzle without success; while Paul Samuelson, in his Foundations of Economic Analysis, called profit a “residuum” that “must be ‘due’ to something,” but never figured out what. Later writers have simply ignored the profit puzzle. According to Godley and Shaikh, “the standard Walrasian model is built on the assumption that profit does not exist” (“An Important Inconsistency at the Heart of the Standard Macroeconomic Model,” Journal of Post Keynesian Economics, 2002).

Mainstream economists either don’t understand why profit exists or they pretend it doesn’t. If this doesn’t shock you, it should. Every business in America strives for profit. Countess stock trades worth trillions of dollars are made at Wall Street on the basis of profit and loss by publicly-traded companies. Shareholders despair that profits are not higher, while left-wing politicians declare that profits are too high. Consumers feel gouged by high prices charged by profit-hungry companies. And yet economists insist that none of this “profit” exists, or that if it does exist, it’s all very puzzling but largely not relevant to the macroeconomic condition of business.

Fortunately, one economist did solve the profit puzzle. His name is George Reisman, Professor Emeritus at Pepperdine University. His life’s work and masterpiece, Capitalism: A Treatise on Economics, is the only work of economics that synthesizes the Austrian and Classical schools into a cohesive whole, along the way solving much that had been deemed unsolvable by either school alone. Reisman’s book is over 1,000 pages long; I have read it twice, once in my 20s while at Harvard Law School and then again in my early 40s after two decades of working as an entrepreneur. I commend it to anyone who wants to understand how the world works; but I recognize as well that few of us in today’s digitally-maddened world, have the time or inclination to read a millennium of pages for an avocation. What I offer below is therefore the briefest summary of Reisman’s theory of monetary profit.

Consider a simple economy consisting of three firms, with a fixed money supply, operating in a perfect circlular flow. As noted above, the Classical and Neo-Classical economists would insist that there can be no profit. We will show that there is.

Firm #1, an Agricultural Business run by Entrepreneur A, spends $2000 on labor to produce $5000 worth of food. To sell what it produces, it spends another $2000 on marketing and distribution of its food.

Firm #2, a Clothing Business run by Entrepreneur B, spends $2000 on labor to produce $5000 worth of clothing. To sell what it produces, it spends another $2000 on marketing and distribution of its clothing.

Firm #3, a Marketing & Distribution Business run by Entrepreneur C, spends $3000 on labor to produce $4000 worth of marketing and distribution services, which it sells to Firms #1 and #2.

Firm #1’s revenue is $5000 and its costs are ($2000 + $2000) = $4000, for a profit of $1000. Firm #2’s revenue is $5000 and its costs are ($2000 + $2000) = $4000, for a profit of $1000. Finally, Firm' #3’s revenue is $4000 and its costs are $3000, for a profit of $1000.

So we have three firms each earning a profit in a fully circular flow! How is this possible? Let’s check our math. We see the total of marketing and distribution services sold by Firm #3 ($4000) equals the cost of marketing and distribution paid by Firms #1 and #2 ($2000 + $2000 = $4000). We actually can generalize from this (and Reisman does so in his treatise): Whenever the economy is viewed as a whole, businesses’ cost of services and/or capital goods is also equal to businesses’ revenue from providing these services or capital goods, and the terms always drop out in a calculation of aggregate profit.

We see that the total value of consumer goods produced is $10,000, with $5000 worth of food and $5000 worth of clothing. The wages paid to labor are $2000 (for farmers), $2000 (for clothiers), and $3000 (for marketers and distributors), for $7000 in total. At this point, a Marxist economist wags his finger and says (to paraphrase Karl) “How can the entire capitalist class manage to draw continually $10,000 out of circulation, when it continually throws only $7000 into it?” Have we run into the profit puzzle?

No, says Reisman, all is well. His solution is as follows: Wage-laborers aren’t the only consumers. Capitalists are also consumers. The money they use to consume is the profit they receive from their ownership of businesses, paid to them in dividends, royalties, profit shares, and so on. The “missing” $3000 of food and clothing is paid for out of the profits. The capitalists eat a lot of expensive food and wear a lot of fancy clothes.

The solution really is that simple. The source of profit in the economy is the consumption expenditure of capitalists. Now, in Capitalism, Professor Reisman elaborates the theory more, showing how profit can be affected by net investment and by a change in the money supply. Those topics merit further discussion, but - again - Capitalism is a book of a 1000 pages and this is merely my evening blog. (I will address the most likely objection briefly: We are here discussing monetary profit, and so attempts to introduce “opportunity costs” in order to claim that “economic profit” doesn’t exist are moot.)

Given how simple the answer is, the real question is why no one before Reisman had solved it. The reason, Reisman believes, is the so-called “primacy of wages” doctrine, to which Reisman contrasts his own “primacy of profits.” The difference between the two can be seen by imaging a hypothetical fishmonger in the Middle Ages, who buys fresh fish from the local fishermen for 40 shillings and sells them to consumers at market for 50 shillings. He is left with 10 shillings, which he keeps for himself and uses on food, clothing, and shelter for himself, his wife, and children. Are those 10 shillings a wage he paid himself? Or are those 10 shillings the profit of his entrepreneurship? If you call them wages, then much bad economics follows (as Reisman’s book demonstrates in many chapters). But if you acknowledge them to be profit, then much of the muddled thinking and paradoxes that plague economic thought fall away.

One of the most important implications of Reisman’s theory of profit is the inverse correlation between a high rate of profit and a high rate of growth in the economy. Since an economy’s rate of profit is determined by the consumption expenditure of capitalists, the rate of profit decreases when capitalists consume less and save more. If capitalists invest those savings into capital expenditures for their business - purchasing new machinery, for instance, or developing new production methods - those capital expenditures will increase the amount of product that can be produced on the same amount of labor, creating economic growth.

Reisman thus also resolves the strange matter of ancient and medieval rates of profit that frequently bedevil players of my Adventurer Conqueror King System. As I wrote in ACKS Axioms 3,

• The average 1-year rate of profit on agricultural product during the 13th-14th centuries in England was 22.3% for wheat, 29.3% for barley, and 22.4% for oats ("Markets and Economic Growth: The Grain Market of Medieval England", Greg Clark, Department of Economics - UC Davis).

• In Old Babylonia, the interest rate on agricultural loans was 33 1/3%. ("How Interest Rates Were Set, 2500 BC - 1000 AD," Michael Hudson,  Journal of the Economic and Social History of the Orient 43, Spring 2000).

• Mortgage lenders in pre-modern France typically required interest of 20-30% of the value of their loan and merchants paid as much as 5-8 % interest per week for working capital (An Essay on Economic Theory, Richard Cantillon).

• The rate of profit on the silver trade between Rome and India during the Hellenistic era was 100%! (The Middle Ages Revisited, Alexander Del Mar).

Such exorbitant rates of profit and interest seem unbelievable to students of modern economics. How could such rates of profit and interest be sustained? Reisman’s theory of profit helps us understand it. Funds in excess of costs were consumed rather than capitalized, leading to high rates of profit but low rates of long-term growth.

Put another way, the reason that for thousands of years, the world’s economic rate of growth was essentially just equal to its rate of population growth, was because capitalists consumed rather than invested. People remained impoverished because Pharaoh built pyramids. It is the opposite of what Keynes claims!

Indeed, pause for a moment and contemplate the above in light of what the so-called Neo-Classical Synthesis tell us about the economy. This mainstream view is found everywhere, from textbooks to news websites to government agencies. Investopedia tells us “In the United States, economic growth is driven oftentimes by consumer spending.” The US Bureau of Economic Analysis says “spending by consumers is a big force in the nation’s economic growth.” Inc.com says “Consumer spending accounts for roughly 70 percent of US economic growth.”

If Reisman is right, the Neo-Classical Synthesis is not just wrong; it is disastrously wrong, ruinously wrong. If Reisman is right, we would expect to see our nation’s manufacturing infrastructure hollowed out, as funds needed for capital investment were diverted to consumption; we would expect to see a growing gap between rich and poor, and an impoverishment of society, as productive expenditure shrinks below the rate of capital depreciation and real wealth dips; we would see real economic growth that was nearly flat, with nothing like the tremendous rates our country achieved in earlier decades. We would, in short, see every ailment we actually do see.

The real profit puzzle is why we have listened to bad economic theories for so long. Monetary profit exists; its source is the consumption expenditure of capitalists; and a high rate of profit, all other things being equal, points to a low rate of investment, which in turn means a low rate of economic growth.

Update: Professor Reisman was kind enough to reach out and suggest some edits on the text above, which I have gratefully made. I have linked his book above on Amazon. For more information on his work, including a free PDF copy of Capitalism, visit the Jefferson School of Philosophy, Economics, and Psychology or Professor Reisman’s blog.